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Person on a tight-rope stretched between two cliffsPortfolio risk is one of the most essential challenges for any investor. More ambitious portfolios can generate greater rewards, creating more wealth in a single year than cautious portfolios can provide over several years of investing. But they can also lose most or all of those gains in an instant if the market turns volatile. Meanwhile, stable and steady portfolios can protect your money, keeping it relatively safe from market downturns and unexpected events. But they also grow slowly, and may not provide the kind of returns you need to meet your financial goals. Managing risk is critical for any investor, more so than ever with the recent market fluctuations. With the right strategies, you can get it right.

Assessing the Types of Risk

The most important step in assessing risk in a portfolio is understanding the types of risk you face. For a retail investor, it’s often helpful to think of risk as three broad categories: asset risk, systematic risk, and portfolio risk.

Asset Risk

This is the risk inherent to any given asset that you have invested in.

Asset risk depends entirely on the individual investment, and differs widely in both degree and kind. For example, the asset risk of a stock tends to be relatively high. Stocks are relatively volatile investments, which can move quickly based on the market, and their risk profile depends strongly on the underlying company. A stock can have risks that involve regulatory changes, tax changes, corporate governance issues or the CEO’s Twitter account. All of these things will affect the value of your investment, and so all create a form of risk.

Meanwhile, a bond has a very different risk profile. These tend to be relatively stable investments, low-yield investments, with most of the asset-specific risk having to do with the likelihood of default on the bond’s underlying debt. Understanding these risks depends on understanding the specific assets in your portfolio.

Systematic Risk

Systematic risks are risks inherent to every asset in a given market. For example, a stock market downturn would be considered a systematic risk, as it would likely affect the value of most stocks. Other issues considered systematic risk are issues such as inflation, Federal Reserve interest rates, legal changes and any other external factors that could affect the value of all your investments at once.

Portfolio Risk

This is the risk inherent to your own portfolio. Many portfolio risks are largely unavoidable. For example, retail investors virtually always face currency risk. Individual investors generally invest entirely in their own currency, such as the U.S. dollar for American investors. This means that as that currency gains or loses value, your portfolio can move with it. Short of investing in foreign markets (often unwise for retail investors) there’s little you can do about this.

However, the structure of your portfolio also can determine its risk. A portfolio heavily invested in certain industries can face industry risk, for example, if those sectors lose value. One with little diversification can face concentration risk, while a portfolio with little potential for growth can face a risk of stagnant overall value.

Mitigating Asset Risk

Financial professional assesses an asset's risk

The best way to manage asset risk is through diversification. Individual assets present as many risk profiles as there are products to invest in. Stocks can provide great returns, but can wipe out just as easily. Mutual funds can provide confidence and stability, but might not generate the money you need to meet your financial goals. Bonds are slow and steady performers, but on the rare occasion they do fail they tend to take your entire investment with them.

Solve this by spreading your money across a mix of assets. In particular, look for investments that have what is known as counter-cyclical behavior. This means that when one investment performs well, the other tends not to and vice versa. For example, stocks and bonds tend to have counter-cyclical performance. The bond market tends to do well when stocks are down, while a booming stock market tends to drive down bond value. Investing this way can help you to offset the risks of one asset with the strengths of another.

Mitigating Systematic Risk

Your portfolio is likely exposed to high systematic risk if it is heavily invested in a small number of specific markets or industries. For example, if you are mostly invested in the stock market or if you have most of your money tied up in real estate, then you likely have a high exposure to systematic risk. Whatever will affect those markets will also probably affect most of your money.

There are a few good ways to manage systematic risk. First, spread your money across several different markets. Perhaps the best way to do this is by investing in mutual funds and exchange-traded funds. These bundled products can give you exposure to a wide variety of markets at the retail investor level. Directly attempting to invest in the commodities market, foreign exchanges, or short sales can often be dangerous for an individual investor, while doing so through a mutual fund can give you diversification without the risks inherent to highly complex investments.

Just as importantly, take a long-term approach to your investing. Systematic risk tends to move in waves, but markets generally regain their value after a period of time. It is hard, if not impossible, to completely protect yourself against market-wide risks on a month-to-month basis. However, if you have built your portfolio around long-term investments, you may have the time to let them recover their value once a specific crisis has passed.

Mitigating Portfolio Risk

Perhaps the most straightforward way to portfolio risk is to invest cautiously. This advice does come with a caveat: The risk of under-investment is real. You do need to balance your investment decisions with your long-term financial goals. It is completely safe to put the college fund entirely into Treasury bonds and a savings account, but those interest rates probably won’t generate enough return to pay for the kids’ tuition. Investment returns matter.

But understanding that context, in general, the greatest risk to your portfolio is losing money, not missing out on gains. Invest cautiously. Build a well-diversified portfolio with the balance of assets weighted towards relatively conservative products such as mutual funds and indexed products. You should have a segment of your portfolio for speculation on products such as individual stocks.

If you are worried about portfolio risk, look first to see if you are heavily concentrated in certain markets or industries. Then look to see how much money you have tied up in high-risk/high-reward investments. Those are both common issues, and good places to start if you’d like to reduce your overall levels of risk.

The Bottom Line

Woman adjusting ziplineManaging risk is an essential skill for any investor. Such an ability enables investors to strike the right balance between overreaching and thus putting their assets at risk and underreaching and thus forgoing capital appreciation. The best place to start in your own finance is to look at whether your risk comes from individual assets, the shape of your portfolio, or the market at large. Often the best solution is to diversify in a direction that ensures that your money isn’t overly exposed in any single direction. On the other hand, there is an opportunity cost to avoiding all risk.

Tips for Managing Risk

  • Consider talking to a financial advisor about managing your portfolio’s risk. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool  can match you with up to three local financial advisors, and you can choose the one who is best for you. If you’re ready to get connected to an advisor near you, get started now.
  • When it comes to investing, risk tolerance is just one factor. You should also consider how long your investments will have to grow. If you’re in a position where you could invest, you should start as soon as you can. Many people invest for their future, and a good retirement calculator can show you why it’s best to invest early and often.

Photo credit: ©iStock.com/aluxum, ©iStock.com/Blue Planet Studio, ©iStock.com/skynesher

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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